The Great Debtscape

Why China's economy is not going to be swallowed alive by its massive deficit.

Since the global financial crisis of 2008, China has persistently defied skeptics who warned of a severe recession or financial collapse. Today the skeptics are louder than ever, as they point to the difficulty Beijing will face in maintaining economic growth even as it tries to discipline an unruly financial sector and cut back on debt. "China's debt-fueled boom is in danger of turning to bust," Ruchir Sharma, head of Morgan Stanley Investment Management's emerging-markets team, warned on Jan. 27. "Only five developing countries have had a credit boom nearly as big as China's. All of them went on to suffer a credit crisis and a major economic slowdown."

But a glance at China's recent history shows why prophecies of doom for the world's second-largest economy should be treated with suspicion.

The first worry after the global crisis was that the country would be unable to wean itself of its addiction to exports. Exports had helped China's economy grow, but fed global instability because of the large trade deficits countries like the United States had to run to offset China's huge surpluses. Yet in the past five years, China's export growth has slowed into the low single digits, the country's share of global exports has stabilized, and the trade surplus has shrunk from 8 percent of GDP to a more sustainable 2 percent.

The next concern was that China would not be able to kick its reliance on infrastructure spending. To maintain economic momentum amid the export slowdown, Beijing authorized local governments to jack up investments, mainly in municipal and transport infrastructure. This drove up the investment-GDP ratio to 47 percent, several points higher than the previous peaks achieved by Japan and South Korea, the other investment-intensive East Asian economies, in similar periods of economic development. Yet in the past two years, infrastructure spending has slowed dramatically, as Beijing has tried to rein in local governments. China's economic growth now relies as much on consumer spending -- which continues to grow at 7 to 8 percent annually in inflation-adjusted terms -- as it does on investment.

In short, over the past five years China has rectified one of its famous "imbalances" -- excessive reliance on external demand -- and made a good start on fixing the other (excessive reliance on investment spending). But a growing chorus of observers views China's economic future with trepidation. In mid-January, Ray Dalio, who runs Bridgewater Associates, the world's biggest hedge fund, declared that China was a bubble. And earlier that month, Patrick Chovanec, a well-known China bear, warned that "China's leaders are riding a runaway train that they don't quite know how to stop."

These worries are plausible. There is no question that China's economy has slowed substantially. From an average rate of more than 11 percent in the last decade, growth is now running at around 7.5 percent, and a further slowdown in the next couple of years is likely. Second, since the global crisis, China's authorities have supported growth by permitting a huge increase in debt. From 140 percent of GDP in 2008, the nation's gross debt soared to 210 percent in 2013. Much of that new debt financed infrastructure projects by local governments, and capacity expansions by the state-owned companies that provided the goods and services necessary for those projects. While a lot of that infrastructure will prove economically beneficial in the long run, in the short term it will generate financial losses. The big questions for China over the next two years are, can it get its debt under control, and, if so, how much of a toll will that take on economic growth?

It is perfectly reasonable to worry that the cost of reining in runaway debt will be another big growth slowdown. It is also reasonable to worry that as Beijing tries to solve the debt problem, the risk of a major financial accident will go up. Since April, the Chinese monetary authorities have tried to curb lending by raising short-term interest rates and imposing more stringent controls on the non-bank "shadow finance" sector. The sector, which includes lightly-regulated finance companies that offer depositors high returns by investing in risky assets, has been responsible for much of the increase in borrowing since 2011. As a result of these new government controls, funding costs for companies and financial institutions are two or three percentage points higher than they were just six months ago, and year-on-year growth in total credit has slowed from 23 percent to less than 18 percent.

These are necessary measures, but they will exact a price. While local governments will be allowed to roll over loans that they are unable to repay, cash-strapped companies probably will not. Corporate bankruptcies will rise, and this in turn could precipitate defaults in the so-called wealth-management and trust products that provide the funding for many "shadow" loans. Wealth-management and trust products offer investors much higher rates of return than ordinary bank deposits -- anywhere from 5 percent to 15 percent. Unlike bank deposits (which are not formally insured but enjoy a strong implicit guarantee from the government), these products are explicitly not guaranteed either by the government or by the financial institutions that sell them. But many investors assume that the government will bail them out -- so defaults could cause a crisis of confidence in China's financial system.

These risks are not simply hypothetical. For weeks, investors have anxiously watched as China Credit Trust, a shadow lender, has worked furiously to avoid default on a $496 million trust product, maturing on Jan. 31, that is built around a loan to a coal-mining magnate in central China who is under arrest. A last-minute deal preserved investors' capital, though not the interest. But it is very possible that some other large-scale trust or wealth-management product will default this year, sending shock waves through the financial system.

Yet despite these undoubted risks, the doomsayers are likely to be disappointed again, and China will manage to avoid both a financial crisis and a severe recession. Instead, it will probably succeed in slowly bringing its debt problem under control, and GDP growth will settle at a slower -- but still more than respectable -- pace of 6-7 percent annual growth over the next three years.

One cause for optimism is that the government of President Xi Jinping, which took power about a year ago, is clearly committed to a sustained policy of tighter money and slower but higher-quality growth. Another is that the systemic risks of a wealth-management or trust product default can be contained, because these products still account for less than 15 percent of the funding base of China's financial system -- the rest comes from stable bank deposits.

Most important, the pessimistic view underestimates the flexibility and dynamism of China's growing private sector. It is this dynamism that has enabled China to absorb the serial shocks of a global liquidity crisis, a sharp decline in export growth, and the more recent slowdown in infrastructure investment, while still maintaining one of the world's fastest economic growth rates. This dynamism is reflected in the small-cap ChiNext stock market in Shenzhen, which was one of the world's best-performing stock markets in 2013 with a gain of 83 percent -- compared to an 8 percent decline in the Shanghai stock index, which is dominated by state-owned firms. And it shows up in the spectacular performance of Chinese Internet companies, which despite the constraints of government censorship have created one of the world's biggest and most vibrant markets for e-commerce, social networking, and online gaming. Betting against the power of China's entrepreneurial spirit has been a losing wager for the last three decades. The odds are it will continue to be a bad bet for several more years to come.



Daft Prez

Was Obama's State of the Union his second farewell address?

As a special service to journalists, commentators, and water-cooler pundits around America, I offer five different ways to frame your comments and thinking about President Barack Obama's State of the Union address -- in terms that will lend the speech some of the zest and creativity it otherwise lacked.

1. Daft Prez

Face it, if the president were a type of music, he'd be techno. And if there were a model for what we saw last night, it might be Daft Punk, the French duo who cleaned up at the Grammys this year for their hit song and album "Get Lucky." The lyrics to the chorus of that song, "We've come too far to give up who we are" also happened to be the theme of Barack Obama's address. In it, he reiterated most of the core policies and plans of his presidency, rehashed some old achievements and promises, and then essentially said, having come this far, if Congress wouldn't let him be, he'd find a way to remain true to himself even if it meant acting alone, via executive order.

Of course, the next line of the song is "So let's raise the bar and our cups to the stars" which, while it suggests higher goals, actually just leads to the refrain that in order to reach those goals, we're going to have to "get lucky." Admittedly, in the song, this means one thing; for America and Obama, getting lucky means something else ... it means that the country's growth is going to depend on the litany of folks outside Washington getting it done, because the government isn't going to be able to do that much. Fortunately, the rest of the country is doing better than its leaders in Washington, and that's why the fact that this State of the Union was pretty formulaic and well, a bit robotic, probably won't matter for most people. Because when Washington checks out, America keeps going and as a consequence, ensures that the State of the Union is well ahead of the state of affairs in the capital.

2. You're a Good President, Charlie Brown

For all his gifts as a speaker, and those were readily apparent last night as the president delivered his hour-long remarks, there was also a certain forlorn quality to Obama's delivery last night. Gone was the audacity of hope. Gone were the grand goals for America. Gone were the assertions that this was a man who could change Washington. This was a president who was resigned to trying to advance his agenda in a dysfunctional Washington. Even his most upbeat statements about the nature of America's economic recovery or the advancement of his international agenda, came with caveats. Yes, we're recovering, he said, but it's really only benefitting the rich and big companies. Yes, we're getting out of Afghanistan, we got out of Iraq, and have pushed back against the old al Qaeda leadership, but the prognosis for the countries we are leaving is grim and al Qaeda is spreading in a new form. But this Charlie Brown president would not have Congress keep pulling the football away every time he tries to kick it. Instead, keeping true to the Charlie Brownian motto, "I love mankind, it's people I can't stand," he said that he would find a way to go it alone, offering up a few areas where he could take executive action that might make a dent, albeit a very modest one, on America's great domestic challenges like slow job creation and burgeoning inequality. 

3. The Drone Presidency

In the midst of his address, buried among the folksy stories and show and tell with the human props populating the First Lady's box (a now standard and cheaply manipulative fare of State of the Union speeches), the president employed a technique worth noting. He argued that he was taking a stand against the use of drones worldwide that has produced such harsh backlash and was reining them in. Of course, he didn't mention that he was actually the guy who dramatically expanded the programs using unmanned aircrafts in the first place. He also took a stand suggesting he wanted to reform the surveillance programs that grew to their present, out of control levels under his leadership. He also called for progress on immigration reform that he essentially ignored throughout his first term (actually overseeing deportations at twice the rate of his predecessor). He also sought to gain credit for calling for Guantanamo Bay to be shut down ... even though doing so was a campaign promise that he has failed to follow through on for five years. In short, some of the key elements of this speech involved the president taking a tough stand against himself -- a bit like launching a drone that is programmed to target its own tail. 

4. Barack Obama's Second Farewell Address

I was recently told by a diplomat friend from elsewhere in our hemisphere that one Latin American head of state posed the theory that Barack Obama's first inaugural address was really his farewell address. In this widely respected leader's view, that was because it was at the moment of that address that he achieved what would inevitably be his biggest accomplishment -- becoming the first African American U.S. president. This other head of state, a man sympathetic to many of Obama's goals, felt it was an accomplishment so big that it would be impossible to top; inevitably, he had already achieved the thing for which history would best remember him.

While neat and not altogether uncommon, the assessment is unfair. During his first few years in office, Obama has accomplished a great deal: from helping to oversee the economic recovery of the United States to ending two misguided American wars to producing substantial health care and financial services reforms. But even if you buy into this Latin statesman's view of Obama's first inaugural, you couldn't help but see in the State of the Union elements of what might then be viewed as a second farewell address.

The speech was that of a man with a limited agenda, with limited hopes of getting much done, hemmed in his job by the most obstructionist Congress in history, buffeted by a world he does not feel he can very well control, finding a glide path for his presidency that would get him safely and with as little turbulence as possible to his ultimate historical destination. As striking as the speech was for the absence of big ideas, it was more striking for its absence of great energy or ambitions. It was clear the president had hoped for more. It was clear that he knows more needs to be done. It was even clear he had some strong ideas about how to do it. But with every goal in the speech there was also an undercurrent of a man acutely aware of the limitations of his office, of the system in which he works and of his consequent inability to do much of what he had once hoped and promised to do. If not exactly a farewell address, it was certainly one suffused with resignation.

5. My 600-lb. Life

If you wanted to see someone really grappling with big problems on Tuesday night as the president spoke, you could have switched channels and watched an episode of "My 600-Lb. Life" -- TLC's reality show that aired opposite the State of the Union. Apparently, most Americans made a similar viewing choice. The ratings for the president's address, despite being shown on every major network and news channel (over 16 channels in all), were low and likely continued the downward slide experienced over the past five years in SOTU viewership. In 2009, his first such speech garnered 52 million such viewers, according to Nielsen, the rating's service, in 2013, the number was down to 33 million. 

If last night held true to form, that means that nine out of 10 Americans were doing something else while the president was talking (which, if you picked up the theme from the opening of the president's remarks, may not be a bad thing). Because in that effective and also telling opening, essentially Barack Obama sent the message that State of the Union is strong despite Washington rather than because of it, driven by Americans going about the business of their lives rather than the women and men who gathered last night to go through yet another largely meaningless ritual on Capitol Hill.

Photoillustration by FP/Photos via Getty Images